No banking union without fiscal union: James Saft

(Reuters) – A banking union, as espoused by the European Commission, is probably totally unworkable unless accompanied by a full fiscal union.

Which is to say a euro zone which features banking union is no different than the current state of affairs, the solution to which, short of a break-up, also almost certainly requires much greater centralization of taxing and spending.

The Commission, the European Union’s executive arm, on Wednesday floated the idea of a banking supervision union to run alongside the 17-nation currency zone.

“A closer integration among the euro area countries in supervisory structures and practices, in cross-border crisis management and burden sharing, towards a ‘banking union’, would be an important complement to the current structure,” the Commission said.

This could include a single deposit guarantee fund and allow greater flexibility to the European Stability Mechanism, a sort of permanent bailout fund set to take effect this July.

“In the same vein, to sever the link between banks and the sovereigns, direct recapitalization by the ESM might be envisaged,” the Commission added.

Of course, you are not severing the link between banks and the sovereigns; you are replacing one sovereign with another. Under the old arrangements, individual states could, with agreement, borrow from the ESM to recapitalize their banks, but the liability for the borrowed funds would lie with the state, as would the primary responsibility for supervision.

This plan still backstops banks with a sovereign, but rather than a state hamstrung by its euro zone arrangements, like Spain is now, you have an over-state in the form of the euro zone as the backstop. The euro zone, or that portion of it devoted to running the banking union, would be the effective ultimate guarantor of all banks in the union.

This will, at a stroke, solve many problems while creating more still, because it will, in essence, be transferring liability for Spanish, Italian, and, yes, French, banks partially to Germany. This will make it easier for Spain to borrow cheaply, because of course it will have shed this awful liability. It will also make it easier for Spanish banks, or at least those which aren’t in hideous distress, to borrow because they will enjoy support from a big, solvent parent: Germany.

THE PRIMACY OF THE BANKS

Doing this acknowledges the current reality – that states which license and insure banks almost inevitably become in some measure subject to them – without doing much about it.

This puts Germany in the position of accepting much of the liability for the last decade or so of loose supervision and poor banking practice. Germany would, at the same time, find itself on the hook for the hundreds of billions of euros of Spanish, Italian and Greek government bonds with which banks have stuffed their balance sheets, partly as a response to policy incentives set up by the ECB. That would allow Spain, just as an example, to run a ruinous deficit safe in the knowledge that Germany would have a massive incentive, as effective banking guarantor, to make sure it wasn’t forced to default.

Germany and the other stronger states could use their influence as part of the banking union supervision to force southern banks to divest themselves of government debt, but that too would prove ultimately self-defeating. The banking union authorities could try to force budget discipline on states by passing rules saying banks must give higher reserve risk weights to bonds of states with larger deficits. Germany would effectively be like China is to the U.S. – it could torpedo southern states by forcing sales of their bonds, but at the same time would suffer grievous wounds itself.

Far better, then, to make banking union, which is almost certainly a necessary reform, go alongside fiscal union. That would imply central control of all of the levers of spending, allowing for a gentle path of fiscal reform and the re-capitalization of banks without huge moral hazard.

Trying to do all that while dealing with the dire situations in Greece and now Spain is like trying to organize a group of fire fighters who’ve never met at the scene of the blaze – you’ll get there eventually but the structure may be a write-off.

It may be that banking union does happen, but if it does two things are at once abundantly clear. First, that Germany and the other stable states have agreed to pay for the errors of others. Second, that fiscal union will either happen within a very short stretch of time or the euro zone will face another, this time even larger, catastrophic break-up.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)